February 28, 2016

The market has decided: Inflation is dead. Wages in the United States will remain stagnant for the foreseeable future. Sluggish growth will persist globally. These are the only conclusions that an objective third party can draw from the current state of the fixed income market—which has all of the tell-tale signs of a bubble: fundamentals don’t seem to matter, policies that derail the bullish treasury thesis are disregarded as mistakes, and market participants cannot remember what a bear market in treasury bonds looks like. In time, investors will look back at the current state of the U.S. treasury market and label it a bubble, but unfortunately, it will be too late.

A wise investor is one that heeds caution when the intelligentsia begin speaking of a new paradigm in financial markets. When phrases like “the new normal” become commonplace, it signals that something is “rotten in the state of Denmark.” The Shakespearean allusion is particularly relevant, since Denmark was the first to adopt a negative interest rate policy. Since then, Switzerland, the Eurozone, and Japan have all followed suit, and there is chatter that the United States is destined to follow. Negative interest rates are the result of a sovereign debt bubble and represent a curious, even ludicrous, state of affairs. The time-value of money has been turned on its head. A dollar today is worth less than a dollar tomorrow, even though Central Banks have the ability to print an infinite amount of fiat currency. It makes no sense. Even more disconcerting is that negative interest rate policies are being interpreted, not as a problem, but rather a solution.

The extended secular bull market in treasuries has its roots in persistent disinflation, or the falling rate of increases in consumer prices. This disinflation has existed for a multitude of reasons, most notably, stagnant wages resulting from an oversupply of labor in the United States. Aging baby-boomers expanded the labor-force population after 1970. Rising female participation rates exacerbated the supply glut. And finally, globalization gave U.S. companies access to a massive pool of cheap labor overseas. However, all of these demographic forces are reversing. The female participation rate topped out in 2000, and the overall working-age population in the United States has been falling since 2007. Outsourcing is less profitable as the cost of labor in BRIC countries quickly catches up to that in the U.S. As the labor supply glut transitions to a shortage, wages will likely breakout of their multi-generational doldrums, and disinflation (and falling yields) will be a relic of the past.

Contrary to popular belief, inflation is not dead. The only thing that is dead is market-based inflation expectations, which have a lousy track-record of predictive value. Currently, the ten-year breakeven inflation rate based on Treasury Inflation Protected Securities (TIPS) is a paltry 1.4%. Meanwhile, the Commerce Department’s report on personal income and spending, last Friday, showed that consumer prices in January were up 1.3% over the last year, in spite of the epic fall in energy prices. Core inflation was up 1.7%, the fastest pace in three years.

When Federal Reserve policy is viewed in the context of economic data, rate normalization seems prudent. Inflation is not dead. The U.S. unemployment rate is almost at pre-recession lows. Job openings are at all-time highs, and quit rates are rebounding. Still, the fixed income market is fighting the Fed tooth and nail. Federal Reserve members are predicting three to four rate increases by the end of 2016. The Fed Funds futures market is predicting zero increases. In fact, the market isn’t fully pricing in a rate increase until 2018, at which point the Federal Reserve expects the short-term borrowing rate to be over 3%. The market is forecasting a much more gradual path of short-term rate hikes than policy-makers. Even more worrisome, is that the market is not considering that it may be wrong. Ten-year treasury yields are comprised of both the projected path of short-term rates and a term premium (the added rate required to reward investors for taking duration risk). The current term-premium is negative .32%. This marks the first time the premium has been negative since 1961, and is the lowest reading ever recorded. The market hubris in bonds is unprecedented. Market forecasts for short-term rates are in direct contrast with the Federal Reserve, and market participants are demanding no compensation for the possibility that they might be wrong. A recalibration of these expectations will cause a significant upward movement in yields. In the early 1960’s (the last time term-premiums were negative), the ten-year yield increased from 4% to 16% over the next twenty years—food for thought.

It is time for the market to consider the possibility that the Federal Reserve’s normalization policy is appropriate, and for market participants to embrace rather than shun it. Then again, large money managers have a strong incentive to keep this bull market perpetuating itself. Fixed income portfolios have ballooned over the last decade and outperformance, given low treasury yields, is predicated on those yields falling further. Perhaps this is the reason that Fed rate hikes are dismissed with fervent ire.

The market realization that wage growth is resurgent due to shifting demographics and that inflation is not dead will pop the sovereign debt bubble. At which point, governments will no longer be paid to borrow money, and the balance of power will finally shift back in favor of savers in the form of higher rates.

This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the author which are subject to change without notice. Forward looking statements, estimates, and other information contained herein are based upon proprietary and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy.  Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.